Report 17 of 2006

______________________________________________________________________________1

1. Introduction 1.1 The process of disinvestment of Public Sector Undertakings (PSU) had been started by the Government in 1991-92. Different methodologies for disinvestment were adopted from time to time such as the auction method1 or partial disinvestment in favour of mutual funds and financial institutions in the public sector, strategic sale2 for privatization between 1999-2000 and 2002-2003 and market sale3, either through initial public offer4 or offer for sale5 for divestment of minority shareholding during 2003-05.

1.2 It was in August 1996 that Government established a Disinvestment Commission (DC) initially for a duration of three years to advise it on all aspects relating to public sector disinvestment. The main terms of reference were

to draw a comprehensive overall long-term disinvestment programme within 5-10 years for the PSUs referred to it by the Core Group comprising Secretaries of selected Ministries;

to determine the extent of disinvestment in each PSU; to prioritise the PSUs referred to it by the Core Group in terms of the

overall disinvestment programme; to recommend the preferred mode(s) of disinvestment for each of the

identified PSUs; to supervise the overall sale process and take decisions on instrument,

pricing, timing etc., as appropriate; to select the financial advisors for specified PSUs to facilitate the

disinvestment process; and to monitor the progress of disinvestment process and take necessary

measures and to advise Government on possible capital restructuring of the enterprises by marginal investments, if required, so as to ensure enhanced realization through disinvestment.

1 Auction is one of the methods for divesting shares under market sale where the pricing is optimised through bidding. It is less time consuming and involves low transaction cost. It is targeted at the institutional investors. In the initial rounds of disinvestment, Government divested its stake in PSUs thorough this method. 2 Strategic sale implies selling of a substantial block of government holdings to a single party, which would not only acquire substantial equity holdings of up to 51 per cent but also bring in the necessary technology for making the public sector enterprise viable and competitive in the global market. Alternatively, Strategic Sale includes two elements, one is transfer of block of shares to a Strategic Partner and the second is transfer of management control to the Strategic Partner. 3 Market sale signifies sale of shares to individuals, financial institutions or private sector business, which can then be traded in the market. It includes the sale of shares through initial public offer, offer for sale to public, international offering, private placement and auction 4 Initial Public offering (IPO) is the first issue of equity shares to the public by an unlisted company. 5 Offer for sale is offer of shares by existing shareholder(s) of a company to the public for subscription, through an offer document.

Report 17 of 2006

______________________________________________________________________________2

1.3 The Disinvestment Commission made recommendations with respect to 58 out of 72 PSUs were referred to it. The recommendations were for strategic sale in respect of 36 PSUs, which involved transfer of management, for offer of part of equity in 6 PSUs and closure/ sale of assets in respect of 4 PSUs. No disinvestment was recommended in the remaining 12 PSUs.

1.4 The Commission was an advisory body and the final decision on the recommendations would vest with Government. The Commission was reconstituted in July 2001 after the expiry of the term of the first DC in 1999, submitted reports on 41 PSUs including four review cases and was wound up in October 2004.

1.5 Government classified (March 1999) the PSUs into those functioning in strategic and non-strategic areas for the purpose of disinvestment. All PSUs except those in the three areas of arms and ammunition and allied items of defence equipment, defence air-craft and warships, atomic energy (except in the areas related to the generation of nuclear power and application of radiation and radio-isotopes to agriculture, medicine and non-strategic industries) and railway transport were to be considered non-strategic. In these non-strategic cases it was decided that the reduction of Government stake to 26 per cent would not be automatic and the manner and pace of doing so would be worked out on a case by case basis. 1.6 Government further decided (March 1999) that divesting their stake to less than 51 per cent or to 26 per cent would be taken on considerations as to whether the industrial sector required the presence of the public sector as a countervailing force to prevent concentration of power in private hands, and whether the industrial sector required a proper regulatory mechanism to protect the consumer interests before the PSUs were privatised. Government also decided to strengthen strategic PSUs, privatise non-strategic PSUs through gradual disinvestment or strategic sale and devise viable rehabilitation strategies for the weak units.

1.7 In December 1999 Government established a new Department for Disinvestment (DOD) to lay down a systematic policy approach to disinvestment and privatisation and to give a fresh impetus to this programme. In the budget speech of 2000-01, Government stated that it was prepared to reduce its stake in the non-strategic PSUs even below 26 per cent, if necessary and that there would be increasing emphasis on strategic sales. It further stated that it would set up a Disinvestment Proceeds Fund and the entire proceeds from disinvestment would be used for meeting the expenditure in the social sector, restructuring of PSUs and retiring public debt.

1.8 Government disinvested its stake in nine PSUs, namely, Modern Food Industries Limited (MFIL), Bharat Aluminium Company Limited (BALCO), Hindustan Teleprinter Limited (HTL), Computer Maintenance Corporation Limited (CMC), Hindustan Zinc Limited (HZL), Videsh Sanchar Nigam Limited (VSNL), Indo Burma Petroleum Limited (IBP), Indian Petrochemicals

Report 17 of 2006

______________________________________________________________________________3

Corporation Limited (IPCL) and Paradeep Phosphates Limited (PPL) between 1999-2000 and 2002-2003 through the strategic sale route in which block of shares, as indicated in the Table 3, along with the management control were passed on to a strategic partner except in the case of IBP where the control had passed on to another PSU, namely the Indian Oil Corporation Limited (IOC). This report examines the disinvestment of these nine PSUs in accordance with the audit objectives spelt out in paragraph 2 below. However, in addition to these cases, Government disinvested its stake in two small PSUs, namely Lagan Jute Manufacturing Company Limited (LJMC) and Jessop & Company Limited (JCL) besides 19 properties of Indian Tourism Development Corporation (ITDC) and three hotel properties of Hotel Corporation of India (HCI) during 1999-2000 and 2003-04.

1.9 Coming to the subsequent developments, the National Common Minimum Programme of May 2004, inter alia, stated that Navaratna6 PSUs were to be retained in the public sector and privatisation was to be considered on a case by case basis. Generally, profit-making PSUs were not to be privatized. While every effort was to be made to modernize and restructure sick PSUs and revive sick industry, chronically loss-making undertakings were to be either sold-off, or closed after all the workers had got their legitimate dues and compensation.

1.10 Government in the budget speech 2004-2005 stated that it would establish a Board for Reconstruction of Public Sector Enterprises (BRPSE) to advise Government on measures to be taken to restructure the PSUs, including cases where disinvestment or closure or sale was justified. BRPSE was to examine only cases of loss-making/potentially sick PSUs referred to or taken up suo-moto by it and make recommendations on disinvestment to Government. BRPSE was established on 6 December 2004. 1.11 Objectives and Progress of Disinvestment 1.11.1 The primary objectives of disinvestment of the PSUs as indicated in the manual of policy and procedure issued by DOD in April 2001 were the following:

releasing large amount of public resources locked up in non-strategic PSUs, for redeployment in areas that were much higher on social priority, such as, basic health, family welfare, primary education, social and essential infrastructure;

stemming further outflow of scarce public resources for sustaining the unviable non-strategic PSUs;

reducing the public debt that was threatening to assume unmanageable proportions;

6Navratna PSUs- Government granted substantial enhanced autonomy to selected 11 PSUs. The criteria for selecting the enterprises included size, performance, nature of activity, future prospects and the potential to develop as world level players.

Report 17 of 2006

______________________________________________________________________________4

transferring the commercial risk, to which the taxpayers money locked up in the public sector was exposed, to the private sector wherever the private sector was willing and able to step in; and

releasing other tangible and intangible resources, such as, large manpower currently locked up in managing the PSUs, and their time and energy, for redeployment in high priority social sectors that were short of such resources.

1.11.2 Government realized disinvestment proceeds of Rs. 47,671.62 crore during 1991-2005, which included Rs. 36,007.20 crore from the sale of minority shares in 43 PSUs during this period and Rs. 1317.23 crore during 2000-2001 from the sale of majority shares of Kochi Refineries Limited (KRL), Chennai Petroleum Corporation Limited (CPCL) and Bongaigaon Refineries and Petrochemicals Limited (BRPL) to sister PSUs. Subsequently, Government adopted the strategic sale route for disinvesting equity in the PSUs during the period from 1999-2004. Government privatised 11 PSUs and 22 hotel properties of HCI and ITDC through the strategic sale route and realized Rs.10,347.19 crore. Of the total proceeds of Rs. 36,007.20 crore, Government realized Rs. 15,205.35 crore and Rs. 2700.06 crore during 2003-04 and 2004-05 respectively by divesting minority shareholding through the market sale route, either through Initial Public Offer or Offer for Sale. Diagram 1 gives a pictorial presentation.

Diagram 1: Government receipts from disinvestment between 1991-92 and 2004-05

1317.23, 3 %

36007.2, 75%10347.19, 22%

Sale of minorityshares

Sale of majorityshares to CPSUs

Strategic sale

1.11.3 The Ministry of Finance reported that the total receipts from disinvestment through strategic sales during the period 1999-2000 and 2003-04 amounted to Rs.10,347.19 crore. This amount actually included only Rs. 6359.07 crore attributable to disinvestment of Government equity. Details of the remaining amount of Rs. 3988.12 crore have been shown in Table 1.

Report 17 of 2006

______________________________________________________________________________5

Table 1: Details of other receipts relating to disinvestment (Rs. in crore)

Sl. No.

Name of PSU Nature of receipt Year Amount realized

1. Bharat Aluminum Co. Ltd.

Pre disinvestment restructuring receipts

1999-2000

275.42

2. Computer Maintenance Corporation

Employees Stock option Scheme

2002-2003 6.07

3. Hotel Corporation of India Ltd.

Receipts realized by Air India, the holding company in respect of sale of three hotel properties

2001-2003

242.51

4. Videsh Sanchar Nigam Ltd. (i) Pre disinvestment restructuring receipts

(ii) Employees Stock Option Scheme

2001-2002

2001-2002

2249.75

25.19

5. State Trading Corporation of India Ltd.

Special dividend 2001-2002 40.00

6. Minerals and Metals Trading Corporation of India Ltd.

Special dividend 2001-2002 60.00

7. Hindustan Zinc Ltd. Employees Stock Option Scheme

2002-2003

6.19

8. Indian Petro Chemicals Corporation Ltd.

Employees Stock Option Scheme

2003-2004 64.81

9. Maruti Udyog Ltd. Renunciation of rights issue of 12,16,341 shares against Rs.1000 crore control premium.

2002-2003 1000.00

10. Jessop and Co. Ltd. Receipts realised by Bharat Bhari Udyog Nigam Limited (BBUNL), the holding company

2003-2004 18.18

Total amount realized 3988.12

1.11.4 Government actually received Rs. 5544.42 crore from strategic sale of nine PSUs covered in this report over the period 1999-2000 to 2002-03, which also included an amount of Rs. 1153.68 crore realized from Indian Oil Corporation (IOC) from the disinvestment of IBP. Details of the receipts through strategic sale in respect of nine PSUs covered in this report are indicated in Table 2.

Report 17 of 2006

______________________________________________________________________________6

Table 2 : Details of the receipts through strategic sale in respect of nine PSUs (Rs. in crore)

Sl.No. Name of PSU Year Amount realized 1. Modern Food Industries Ltd. 1999-2000 105.45

2. Bharat Aluminum Co. Ltd. 2000-2001 551.50

3. Hindustan Teleprinter Ltd. 2001-2002 55.00

4. Computer Maintenance Corporation 2001-2002 152.00

5. Indo Burma Petroleum Company Ltd. 2001-2002 1153.68

6. Videsh Sanchar Nigam Ltd. 2001-2002 1439.25

7. Paradeep Phosphates Ltd. 2001-2002 151.70

8. Hindustan Zinc Ltd. 2002-2003 445.00

9. Indian Petro Chemicals Corporation Ltd. 2002-2003 1490.84

Total amount realised 5544.42

1.11.5 In addition, Government realised Rs. 367.95 crore from the exercise of put option7 and call option8 in respect of MFIL and HZL under the Shareholders Agreement (SHA) during 2002-03 and 2003-04 respectively. Government also disinvested LJMC and 19 hotel properties of ITDC and realized Rs. 446.70 crore during the period 2000-2003.

1.11.6 The total receipts of Rs. 10,347.19 crore represented an average contribution or realization of Rs. 2586.80 crore per year during the period of four years ( 1999-2000 to 2002-03 ) and constituted 1.84 per cent of the average net accrual accretion of internal debt (Rs. 1,40,248.25 crore) for the same period of four years ending 31 March 2003. Similarly, these receipts amounted to 6.75 per cent of the average annual expenditure of Rs. 38,298 crore incurred by Government on social sector schemes for the above mentioned four year period. In view of the fact that the receipts were not kept in any separate or distinct account these funds became fungible with the other receipts in the Consolidated Fund of India, making it difficult to assess the end use of the funds.

1.11.7 Audit noted that Government could achieve targeted receipts on account of disinvestment projected in the budget statements during 1991-92, 1994-95, 1998-99 and 2003-04. However, the actual receipts for the period 1999-2000 to 2002-03 when disinvestment was carried out mainly through strategic sale, could not reach the budgeted target. The actual receipts worked out to 18.60 per cent, 18.71 per cent, 47.15 per cent and 27.90 per cent of the respective targets during 1999-2000, 2000-01, 2001-02 and 2002-03.

7 Put option is an option to sell an asset at a specified price on or before a specified date 8 Call option is an option to buy an asset at a specified price on or before a specified date

Report 17 of 2006

______________________________________________________________________________7

1.12 The process of Disinvestment 1.12.1 Prior to the setting up of a separate Department of Disinvestment (DOD) in 1999, the disinvestment of Government equity in selected PSUs was carried out by the Department of Public Enterprises (DPE) in association with the concerned PSUs and their Administrative Ministries/ Department, the Ministry of Finance and the Cabinet Secretariat. Other Central Government Ministries/ Departments were co-opted on the basis of the requirement of a particular transaction The department was given the status of Ministry of Disinvestment in September 2001. Subsequently, in May 2004, it was converted from an independent Ministry to the Department of Disinvestment (DOD) under the Ministry of Finance. DOD was responsible for taking each proposal to the Cabinet Committee on Disinvestment (CCD), the highest decision making body in the approval channel as indicated in the Diagram 2 below. Government decided (June 2004) to assign the responsibility for taking decisions relating to disinvestment to the Cabinet Committee on Economic Affairs (CCEA).

n An Evaluation Committee (EC) comprised the Additional Secretary and Financial Advisor of the Administrative Ministry, Joint Secretaries of select ministries including the concerned administrative Ministry.

o The Inter-Ministerial Group (IMG) was the third tier where inter-ministerial consultation took place at the primary level and was chaired by the Secretary, Department of Disinvestment and comprised officers of the of select ministries including the concerned administrative Ministry, the Chairman and Managing Director and the Director (Finance) of the PSU concerned.

p The Core Group of Secretaries (CGD) the second highest tier in the decision making process, was headed by the Cabinet Secretary and comprised Secretaries of select ministries including the administrative Ministry and Planning Commission.

q The Cabinet Committee on Disinvestment (CCD), the highest decision making committee headed by the Prime Minister was formed in February 1999, and comprised Ministers from various departments including the Minister concerned with the PSU under disinvestment.

Administrative Ministry

Examining the views of DC and coordinate between Department of Disinvestment and PSU

PSU Preparation of PIM Assist GA in preparing of the

IM by providing all information about the company required by GA

Selection of Intermediaries was being done by PSUs concerned till February 2001 and thereafter, intermediaries were selected by the Department of Disinvestment

Assist GA in setting up of Data Room

Evaluation Committeen

Inter-Ministerial Group headed by Secretary, Disinvestmento

Core Group of Secretaries on Disinvestmentp

Cabinet Committee on Disinvestmentq

Department of Disinvestment

Constitute the Inter Ministerial Group.

Appointment of Global Advisor Constitute the Evaluation

Committee. Preparing notes for Core Group

on Disinvestment and Cabinet Committee on Disinvestment

Report 17 of 2006

______________________________________________________________________________8

1.12.2 Advisors and Intermediaries The Department of Disinvestment (DOD) was to be assisted by various Advisors and Intermediaries in the management of disinvestment. These included an overall Advisor known as the Global Advisor (GA) or Financial Advisor, legal advisors and asset valuer. In addition, Environmental Consultants, Mining Experts, Chartered Accountants, Accounting Adviser and Public Relations firms were also appointed for disinvestment of PSUs depending on requirement.

1.12.3 Global Advisor (GA) GA was to assist the DOD and Government in all aspects of disinvestment transactions whose responsibilities, inter-alia, covered suggesting measures to enhance the sale value, preparing a detailed information memorandum, marketing the offer, inviting and evaluating the bids, assisting during negotiations with prospective buyers, drawing up the sale and other agreements and advising on post-sale matters. Advisors were to be appointed through an open competitive bidding procedure after inviting Expression of Interest9 (EoI) from them to submit their proposals. They were to make a presentation before the Inter Ministerial Group (IMG). The Ministry of Disinvestment was to adopt criteria depending on their strategic sale experience, sector expertise and experience, local presence and the understanding of the PSU, as approved by the Core Group for short listing them. The fees payable to GAs were generally of two types, namely success fee which was a fixed percentage of the gross proceeds to be received by Government from the disinvestment and drop dead fee which was a lump sum amount payable to GA only in the event of the transaction being called off by Government.

1.12.4 Legal Advisor Legal advisors were appointed on contractual basis to look into the legal issues and help the Department of Disinvestment (DOD) in drafting and finalising various agreements. They were responsible for ensuring compliance with legal requirements and that there were no defects in title to properties. They advised DOD on issues related to material contracts, loan and lease agreements, title deeds and insurance cover. 1.12.5 Asset Valuer The asset valuation was conducted by an asset valuer, normally selected by an inter-departmental committee, comprising representatives of the Department of Disinvestment and the administrative Ministry and the Chairman and Managing Director of the PSU from a panel recommended by GA. The Asset Valuer was 9 Expression of Interest containing background information about management, ownership structure, business activities including joint ventures, legal capacity of the company/consortium, participating in a privatization transaction, was to be submitted by the interested party at the prescribed address by the stated deadline. It was to be normally submitted along with a statement of legal capacity and a litigation impact statement.

Report 17 of 2006

______________________________________________________________________________9

paid a lump sum amount as fees. While assessing the fair value of the property, the valuer was to take into consideration the status of the title of the company over the land and buildings, any restrictive covenants incorporated in the title documents imposing limitations on the use or transfer of the property, values at which transactions had taken place in the recent past for properties of comparable nature. The valuer was also to conduct valuation of plant and machinery, mines as well as intangibles, if required.

1.12.6 A process flow chart depicting the various stages of a typical disinvestment transaction through the strategic sale route is indicated at Annex-I. 1.13 Formulation of guidelines for disinvestment of PSUs The Ministry formulated guidelines for valuation of PSUs (May 2001) and for the qualification of advisors as well as bidders (July 2001). The disinvestment of MFIL and BALCO was completed before the issue of these guidelines though the process outlined therein was generally followed.

1.13.1 Guidelines for valuation of PSUs The Disinvestment Commission had, inter-alia, emphasised that valuation of the PSU proposed for disinvestment should be independent, transparent and free from bias and had suggested that three methods of valuation, namely the 'Discounted cash flow' (DCF), Relative valuation' approach and 'Net asset value' approach could be adopted. The Ministry of Disinvestment issued the guidelines in May 2001 according to which four methodologies, namely Discounted Cash Flow (DCF) Method, Transaction Multiple Method, Balance Sheet Method and Asset Valuation Method were to be used for valuation of the PSU to be disinvested. The methodologies are outlined in Annex II. While the first three are business valuation methodologies generally used for valuation of a going concern10, the last methodology is generally considered for valuation of assets especially in case of liquidation11 of a business though it also indicates the replacement cost of the assets of the business. In the case of listed companies, the market value of shares during the last six months could also be used as an additional indicator, for valuation of the companies.

1.13.2 Guidelines for qualification of advisors The Ministry prescribed additional criteria (July 2001) for the qualification of advisors and prospective strategic partners. These provided for disqualification on account of any conviction by a court of law or indictment or adverse order by a regulatory body relating to a grave offence and matters relating to security and integrity of the country. The advisors were also required to furnish an undertaking to the effect that there was no conflict of interest as on the date of their appointment as advisors in handling the transaction and that, in future, if

10 Going concern envisages continuance of operation of the business by infusion of superior technical and managerial skills besides additional capital. 11 Liquidation would involve selling all assets of an enterprise instead of selling it as a going concern.

Report 17 of 2006

______________________________________________________________________________10

such a conflict of interest arose, they would immediately inform Government of the same.

1.13.3 The share purchase and shareholders agreements12 were two vital documents in the process of strategic sale, which were also called transaction documents13. The shareholders agreement (SHA) was to set out the conditionalities agreed between Government and the strategic partner (SP) regarding how the affairs of the company would be managed after the disinvestment. Similarly, the share purchase agreement14 (SPA) was to describe the shares being sold, the purchase price and several representations and warranties and covenants of SP and Government such as post closing adjustments in the case of unlisted PSUs. It was imperative that the Ministry carefully balanced the competing interests of all stakeholders in drafting these agreements and specifically ensured that no undue concessions or benefits were conferred on SP, especially by default or through ambiguities in the agreements.

2. Scope of Audit and Audit Objectives 2.1 Scope of Audit 2.1.1 Major transactions relating to disinvestment of Government shareholding during the period 1999-2000 to 2002-2003 in nine PSUs, namely, Modern Food Industries Limited (MFIL), Bharat Aluminium Company Limited (BALCO), Hindustan Teleprinter Limited (HTL), Computer Maintenance Corporation (CMC), Indo Burma Petroleum Company Limited (IBP), Videsh Sanchar Nigam Limited (VSNL), Paradeep Phosphate Limited (PPL), Hindustan Zinc Limited (HZL), and Indian Petrochemicals Corporation Limited (IPCL) were examined and the results are presented in this report. The records pertaining to post closing adjustment in the case of unlisted disinvested PSUs (MFIL, BALCO, PPL, and HTL) could not be examined as the cases were not finally decided by Government till May 2006. A profile of the PSUs divested through the strategic sale route examined in audit and covered in this report is given in Annex-III. 2.1.2 Disinvestment of the identified stake in each of the nine PSUs took nearly four years to be completed. The strategic sale process was used for the first time

12 Shareholders Agreement (SHA) defines the rights and obligations of both the parties; it reflects the protection of employees rights, business plans, indemnification clauses etc. SHA is entered into among the President of India (acting through the Joint Secretary of the administrative Ministry), the company and the strategic partner. 13 Transaction document consist of Shareholders Agreement (SHA), Share Purchase Agreement (SPA) and Guarantee Agreement. 14 Share Purchase Agreement (SPA) describes the purchase price, mode of payment and the actions at closing time. It also lays down representations and warrantees given by both the parties. SPA was to be entered into among the President of India (acting through Joint Secretary of Administration Ministry), the company and the strategic partner (SP).

Report 17 of 2006

______________________________________________________________________________11

by Government in these cases that involved considerable preparatory work and complex valuation exercises. Outcome of the process of disinvestment did not follow immediately after the sale of the identified stake. Issues arising out of the implementation of the share purchase agreement and share holders agreement were not resolved even several years after the completion of the process of disinvestment. It was thus necessary to allow adequate time to elapse before subjecting the process of disinvestment to an audit scrutiny so that audit could cover all significant issues and frame practical recommendations for further improvement of the process of disinvestment.

2.1.3 Inspection reports were issued on each case of disinvestment of nine PSUs followed by a draft consolidated report to the Ministry. Findings included in the draft report issued in February 2006 were discussed in an exit conference with the Ministry in April 2006. Reply received from the Ministry in May 2006 has been taken into account while preparing this report.

2.2 Audit objectives

2.2.1 The Audit examination essentially had the following objectives:

To examine whether the procedure for disinvestment was well defined with reference to the objectives of disinvestment;

To verify the extent of achievement of the objectives of disinvestment as laid down in the guidelines on disinvestment of the Ministry;

To assess the consistency of application of the prescribed procedures including the valuation methodologies adopted for sale;

To seek assurance that the procedure of disinvestment had generated adequate competitive tension so as to obtain the best value; and

To examine the efficiency of the management of the process of disinvestment, especially in adequately protecting Governments interests before, during and after the disinvestment.

3. Audit Findings

Before discussing the audit findings in detail, it would be relevant to note the essential details of the immediate outcome of the process of disinvestment followed in respect of nine PSUs examined in this report. The final bid price exceeded the reserve price in seven out of nine PSUs disinvested. While the reserve price was not fixed in MFIL, the final bid price was less than the reserve price in PPL. These results would need to be viewed in the light of the audit findings described in the following paragraphs. Table 3 gives a birds eye view of disinvestment of Government shareholding in the nine PSUs.

Report 17 of 2006

______________________________________________________________________________12

Table 3: Details of status of disinvestment of nine PSUs (Rs. in crore)

Sl. No.

Name of PSU

Percentage of equity divested

Reserve price

Final bid price accepted

Name of Strategic Partner

1. MFIL 74 Not fixed 105.45 Hindustan Lever Limited 2. BALCO 51 514.4 551.50 Sterlite 3. HTL 74 38.80 55.00 Himachal Futuristics Limited 4. CMC 51 108.88 152 Tata Sons Limited 5. IBP 33.59 377 1153.68 Indian Oil Corporation 6. VSNL 25 1218.37 1439.25 Panatone Finvest Limited 7. PPL 74 176.09 151.70 Zuari Maroc Phosphates Limited 8. IPCL 26 845 1490.84 Reliance Petroinvestment Limited 9. HZL 26 353.17 445 Sterlite Opportunities and Ventures

Limited

3.1 Difficulty in assessment of achievement of objectives of disinvestment. 3.1.1 Audit examination revealed that the procedure for disinvestment through the strategic sale route was generally well defined and laid down in the manual of policy and procedure issued by DOD in April 2001 followed by guidelines on valuation in May 2001. The procedure was essentially based on the experience of DOD gathered from the sale of Government stakes in MFIL and BALCO that were completed before April 2001. The approval process involved a multi tier mechanism comprising groups of experienced officials commencing from IMG and going up through CGD to CCD which was the final decision taking authority. An Evaluation Committee (EC) was also separately formed for the purpose of making initial recommendation on the reserve price for each PSU under disinvestment after taking into account the presentation of the Global Advisor (GA). These groups or committees had the benefit of the assistance and reports of expert advisors and other intermediaries who were to be appointed through a transparent mechanism and also had access to the legal and other relevant technical advice required for the purpose.

3.1.2 Audit noted that while the broad objectives of the overall disinvestment programme were laid down, individual sale objectives were not clearly spelt out prior to taking up the individual sale transaction. The nine PSUs examined in this report comprised listed, unlisted, loss making as well as profit making PSUs spread across various sectors, and clear individual objectives would have enabled a comprehensive assessment of the extent of their achievement.

3.1.3 Creation and operation of the Disinvestment Proceeds Fund by transferring the sale proceeds to the fund as initially intended in the policy statement of Government in 2000-01 would have enabled transparent and effective deployment of the resources mobilized for the intended purposes. This would have, in turn, enabled a reasonable assessment of the outcome of each disinvestment with reference to its contribution to the achievement of the primary objectives of disinvestment. In the absence of such a mechanism and no other

Report 17 of 2006

______________________________________________________________________________13

clear evaluating tool at its command, the Ministry of Disinvestment was not in a position to assess the extent to which the resources mobilized were actually utilized for meeting the expenditure on social sector or for restructuring the PSUs or for retiring public debt.

3.2 Preparatory work needed better and more effective coordination 3.2.1 Audit examination revealed that BALCO, VSNL, PPL and IPCL did not have clear titles to all the real estate, land and buildings in their possession as noticed from the records produced and examined. Unless the titles to the land were clear, it would not have been possible for the value of such land to have been accounted for in the business valuation of the PSU for fixing the reserve price properly. One of the reasons for not valuing these properties properly was that neither the PSU nor the administrative Ministry nor DOD had made adequate efforts to ensure that clear title deeds were in their possession or to remove encumbrances on the land and buildings before taking up disinvestment. Consequently, the asset valuers had either discounted or not considered the value of such properties.

3.2.2 The Ministry of Finance in their reply (May 2006) stated that they were not required to issue any instructions/guidelines to the entities to be divested to keep their records/ documents in proper shape. As part of their normal functioning, the PSU concerned was expected to maintain all the requisite documents without being directed either by the administrative Ministry or the Department of Disinvestment (DOD). The Ministry while accepting the validity of the issue raised by Audit added that the Department of Public Enterprises would be requested to take up this matter and to issue suitable instructions to all administrative ministries/ PSUs to update the position regarding title deeds as well as encumbrances on land and buildings owned by PSUs. It is to be noted that the Ministry of Disinvestment was established precisely to ensure efficient coordination amongst all concerned agencies including the administrative Ministry and the PSU concerned and for this purpose had all the assistance of expert advisors at its command. The reply of the Ministry only underlined the absence of the good practice of fulfilling the basic requirement of ensuring clear titles to the land and buildings in respect of PSUs already identified and slated for disinvestment. The Department of Disinvestment intimated Audit (July 2006) that the Department of Public Enterprises had issued necessary instructions on 30 June 2006 to all administrative ministries. 3.2.3 Relaxation of conditions of disinvestment after issue of Expression of Interest (EoI). Audit examination also revealed that crucial decisions having substantial financial implication were taken after inviting EoI from prospective bidders in the case of VSNL, PPL and IPCL. 3.2.3.1 VSNL: EoI for selection of the strategic partner (SP) was called on 19 February 2001 and financial bids for acquiring 25 per cent stake in VSNL were received on 1 February 2002. Initially, one of the conditions was that the

Report 17 of 2006

______________________________________________________________________________14

prospective SP should furnish Earnest Money Deposit (EMD) of Rs. 500 crore in cash along with the financial bid. Though IMG did not agree (May 2001) to the request of the bidders for the conversion of EMD into bank guarantee of a lesser amount, IMG modified (November 2001) the EMD from Rs. 500 crore in cash to Rs. 250 crore in the form of irrevocable bank guarantee. Audit examination revealed that the amount of bank guarantee was sought to be further reduced to Rs. 100 crore in the note of the Ministry to CCD (02 February 2002). Similarly the decision to indemnify the SP to the extent of 25 per cent of the total tax liability subject to a maximum of Rs. 150 crore payable by the disinvested PSU, if certain deductions claimed by the latter under section 80(IA) of the Income Tax Act were not finally allowed, was taken only on 17 January 2002. The Ministry of Finance stated (May 2006) that both these decisions had been taken prior to the date of receipt of financial bids on 01 February 2002 and the date of the valuation report of GA. These decisions were thereafter approved by Government (5 February 2002) after the disinvestment on 02 February 2002. While procedurally the decisions were not irregular, resolution of the issues before calling for Expressions of Interest (EoI) would have imparted greater clarity to the matter for the prospective bidders and instilled transparency into the process besides putting in place a good practice.

3.2.3.2 The most favoured customer status awarded at the fag end of the time limit for receipt of financial bids The Ministry of Disinvestment became aware that if a clarification to the effect that the two sister PSUs namely, BSNL and MTNL were directed to route their international calls through VSNL at least for some length of time after disinvestment, it would enhance the attractiveness of the offer. The Ministry of Disinvestment took up the proposal for the same with CCD on 23 December 2001 though the EoIs for selection of SP were invited on 19 February 2001. The decision conferring the most favoured customer status to VSNL by MTNL and BSNL for routing the International Long Distance (ILD) calls by the latter PSUs through VSNL at market rates for a period of two years after transfer of management control to the strategic partner (SP) was communicated by the Department of Telecommunication (DoT) to VSNL on 29 January 2002, two days before receipt of financial bids. The Ministry of Finance in its reply in May 2006 did not explain the delay in taking up the proposal much earlier and why it had to wait till 29 January 2002 to clarify the issue to the bidders though the expert GA was in place on 05 March 2001 and could have alerted the Ministry suitably. 3.2.3.3 Withdrawal of contingent liability of Rs. 1402.80 crore There was a major contingent liability of Rs. 1402.80 crore as the Income Tax Department had disallowed deduction of licence fees paid by VSNL since 1995-96 and retrospectively for 1993-94 and 1994-95 whereas VSNL claimed it as deductible expenditure under Sec 37 of the Income Tax Act. The Income Tax Appellate Tribunal passed an order in favour of VSNL against which the Income Tax Department filed an appeal in the High Court. The initial proposal for

Report 17 of 2006

______________________________________________________________________________15

disinvestment of VSNL was approved by Government on 01 February 2001 but it took the Ministry till 26 December 2001 to obtain the decision of Government to the effect that the advice of the Ministry of Law on the issue would be binding on both VSNL and the Department of Revenue. Ultimately, the Department of Revenue agreed on 30 January 2002 to withdraw the case pending before the High Court. The Ministry of Disinvestment intimated the same to the bidders through GA on 31 January 2002 even as the financial bids were to be opened on 1 February 2002 at 4 PM. Had the process of withdrawal of contingent liability been decided by the Ministry earlier after more effective coordination with all concerned and the decision communicated to the bidders well before submission of bids, a better assurance would have been provided that the bidders had taken into account the effect of such withdrawal before submitting their bid, especially as the amount involved was almost equal to the value for which VSNL was ultimately sold to the strategic partner (SP). This decision had the potential of attracting more bidders and could also perhaps have prevented some withdrawals from the bidding process. The Ministry of Finance in their reply (May 2006) stated that VSNL was a listed company. The contingent liability, including its quantum and the nature was disclosed in the annual accounts of the company. The prospective bidders were also aware of this fact. They, however, stated that the audit observation that such issues should be settled prior to invitation of EoIs would be kept in view in future disinvestments. The Ministrys reply that the bidders were aware of the contingent liability misses the facts that the amount involved and the decision to withdraw the same were significant enough to have made the acquisition more attractive with the attendant prospects of higher bids being offered.

3.2.3.4 Delay in demerging identified surplus land The Department of Telecommunications (DOT) informed the Ministry on 21 January 2002, (10 days before the receipt of financial bids) that 773.13 acres of land had been declared surplus out of 1230.13 acres of total land belonging to VSNL. The surplus land was to be demerged in favour of a resulting company, which was to have a shareholding pattern identical to VSNL as on the date of demerger. The Ministry asked the asset valuer not to value the surplus land and hence the value of surplus land remained out of the valuation exercise undertaken by the Ministry of Disinvestment. Audit noted that the Ministry of Disinvestment had not specified any time limit for completion of the demerger plan in the Shareholders Agreement (SHA) and the actual demerger had not taken place till May 2006 after disinvestment of the PSU in February 2002. As a result, the surplus land was still in the custody of the disinvested company in which SP had management control and could acquire majority shareholding. Regarding the transfer of surplus land of VSNL, the Department of Disinvestment (DOD) intimated (June 2005) Audit that DoT was actively pursuing the issue. Further, in response to audit queries, on 30 September 2005, DOD stated that on 17 January 2005, the strategic partner (SP) had incorporated a

Report 17 of 2006

______________________________________________________________________________16

private realty company with an authorized capital of Rs. 25 lakh and paid up capital15 of Rs. 5 lakh and all the three Directors were to be private persons. The draft scheme of arrangement and demerger prepared by SP was stated to be under examination from the legal angle in DOT, which had also constituted a committee to expedite the process of demerger of surplus land of VSNL. The Ministry of Finance in their reply in May 2006 stated that this was a post disinvestment issue and was being handled by the Ministry of Communications and Information Technology. The Ministry also stated that the call option16 restricted SP from calling all the shares held by Government who shall have at least one share in VSNL and that the affirmative right of Government on matters such as sale of land survived as long as Government remained a shareholder. The Ministrys reply was not convincing. SP had the option to purchase the remaining shares (except one voting equity share) of Government at a predetermined fair value, after February 2006 and Government was obliged to allow it. SP could also sell the surplus land in the case of demerger not taking place and was required to pay only 25 per cent of the benefit accruing from such sale to Government according to the shareholders agreement. As Government had retained 26 per cent shareholding in VSNL after disinvestment, Government was entitled to a share in the sale proceeds of surplus land in proportion to the percentage of further sale of equity to SP. Government could at best have blocked the proposal of SP to dispose of the surplus land which, in effect, would have meant only locking up the value in land depriving Government of any benefit out of the land to be demerged. Further, the shareholding pattern of the resultant realty company was to be the same as on the date of demerger. With more time taken for demerger the SP had the opportunity to increase its shareholding through secondary market. Thus, the delay in finalising the arrangement had the potential of conferring unquantifiable benefit from the sale of surplus land on SP in proportion to its shareholding acquired from secondary market on the date of demerger. More than four years have passed since the disinvestment and Government had not been able to derive any benefit from the surplus land of the PSU. Incidentally Audit noticed that in the case of disinvestment of IBP, the subsidiary (Balmer Lawrie and Company Ltd.) was demerged prior to the disinvestment of IBP, a good practice that could have been followed in VSNL too.

3.2.3.5 PPL: Governments decision of a limited financial restructuring of the PSU by converting preferential shares of Rs. 117.65 crore and loan of Rs. 85 crore into equity was taken on 16 January 2002 which was 10 months after calling of Expression of Interest (EoI) in March 2001 and 23 days before inviting the financial bids. Expeditious decisions on significant issues such as financial restructuring of PSUs and their prompt implementation are good practices that 15 Paid-up capital is capital credited as paid up. 16 Call Option is an option to buy an asset at a specified price on or before a specified date.

Report 17 of 2006

______________________________________________________________________________17

would have only helped in making the process of disinvestment more robust and successful. The Ministry of Finance in their reply (May 2006) stated that finalization of financial restructuring schemes of sick PSUs was, in practice, a time-consuming process, requiring inter-ministerial consultations and approval of competent authorities. However, they agreed that the suggestion of Audit to settle such issues prior to invitation of EoIs would be kept in view in future. 3.2.3.6 IPCL: The profitability and attractiveness of the PSU were dependent on some crucial issues such as the continued availability and the cost of feedstock, which was being purchased from other PSUs, namely ONGC and GAIL. In addition, there were certain unresolved issues relating to deferred taxation (Rs. 750 crore) and other contingent liabilities (Rs. 168 crore), settlement of which before the calling for EoIs would have enabled generation of increased competition. The PSU had taken up the issues of continued availability and the cost of feedstock, deferred taxation and contingent liability with the administrative Ministry in July 1998 before the decision of disinvestment was taken in December 1998. The short listed bidders had also sought clarifications on the issues in September/ October 1999. GA had also admitted (April 2002) in their valuation report that the liability of Rs. 750 crore on account of deferred taxation and Rs. 168 crore relating to contingent liability would affect the valuation. Audit noted that the agreement for supply of feedstock by ONGC/GAIL was finally drawn in May 2002 whereas the bidders submitted the financial bids on 29 April 2002. The issues of deferred taxation and contingent liability were not settled unlike in the case of VSNL where a contingent liability of Rs. 1402.80 crore was settled, though belatedly, through the intervention of the Ministry, as mentioned in paragraph 3.2.3.3. 3.2.3.7 Government approved (16 December 1998) the sale of 25 per cent of government equity in IPCL. Subsequently, Government decided (18 November 2000) to transfer the Vadodara Plant, one of the three plants owned by IPCL to the Indian Oil Corporation (IOC) on the basis of a proposal initially mooted by IOC. But later on Government reversed its decision and decided (13 November 2001) that the equity offered for strategic sale in the first lot be raised to 26 instead of 25 per cent as initially proposed by DOD with the commitment of further disinvestment of at least 25 per cent equity. The Ministry of Finance in their reply (May 2006) stated that initially, Government had decided to disinvest 25 per cent in IPCL through strategic sale. Thereafter, IOC had pointed out that IPCLs Vadodara plant was adjacent to IOC refineries and was meant to be an outlet for Naphtha produced in the refinery. In view of the synergy of operations and the interests of IOC and IPCL, the Vadodara plant of IPCL was decided to be transferred to IOC after proper valuation of assets and only the remaining two units of IPCL (at Nagothane in Rajgarh and at Gandhar in Bharuch) were to be disinvested. The Group of Ministers (GoM) deliberated on the view of the Ministry of Petroleum and Natural Gas that it was very important for IOC to take over all the three units of IPCL in order to ensure downward integration and the formers long term sustenance. It was considered that the sale of IPCL to IOC would send a negative signal from the view point of Government policy on

Report 17 of 2006

______________________________________________________________________________18

reforms. This was also considered to deny Government the advantage of competitive bidding. As IOC was also not into the petro-chemicals sector and did not have expertise in this sector, it was felt that there would be no advantage that would accrue to IOC by earmarking the transfer of IPCL to IOC. Objections were stated to have been received on behalf of small investors who felt that they would not benefit from the merger, as there would be no open-offer obligation on IOC. After considering all the above factors, Government decided (November 2001) to proceed with the strategic sale of 26 per cent equity in IPCL without separating the Vadodara plant. Government also decided to issue fresh advertisement for disinvestment of 26 per cent equity in IPCL. 3.2.3.8 The decision on crucial aspects of the disinvestment of IPCL that were raised by the administrative Ministry could not be taken for over three years. The uncertainty that had thus prevailed in this disinvestment did not help infuse clarity of intent and purpose into the process of disinvestment which was not a good practice conducive to the achievement of one of the primary objectives of disinvestment, namely obtaining the best value for the stake on sale. There should also be clarity on whether the stake in PSU ought or ought not to be sold to another PSU as allowing it may not be in line with the spirit of disinvestment and disallowing the same might not generate adequate competition for effective price discovery.

Recommendation The Ministry may ensure through improved and effective coordination with

the administrative Ministries and the PSUs identified for disinvestment that the titles to all properties are in place and their valuation is carried out properly on the basis of their market value. This would enable Government to obtain correct valuation in their independent exercise undertaken through the Global Advisor and the asset valuer.

The Ministry may also ensure that decisions on extinguishments of liabilities and other major pending issues are expedited well before the calling of EoIs. This would enable the interested and qualified parties to take into account correct and deserved valuation while submitting their bids.

3.3 Appointment of Global Advisor (GA) and other intermediaries 3.3.1 Opening of financial bids GA was the most important technical expert in the process of disinvestment as the business valuation worked out by it formed the basis for arriving at the reserve price in all nine PSUs examined. GA also played an important role in selection of other intermediaries and was instrumental in effectively marketing the sale of these PSUs. The process of selection of GA would have to be transparent, fair and objective. The guidelines of the Ministry also recognized this fact and had standardized the evaluation criteria and weightages to be assigned to each for determining the technical competence of the prospective Global Advisors (GA), as decided by CGD on 1 April 1999. Audit noted that the selection of advisors was done through open bidding process in all the cases and

Report 17 of 2006

______________________________________________________________________________19

the selection committee, (IMG) evaluated the bidders on the basis of the identified criteria and weights in all cases. An average of the scores given by the members of the IMG on each criterion was arrived at and thereafter a weighted average score for each bidder was calculated. However, no threshold score or benchmark score was prescribed for short listing the bidders based on technical qualification before opening their financial bids. As a result, financial bids of only a few bidders ranging between one and three (as decided by IMG in each case) out of those who made presentations before IMG were finally opened as indicated in Table 4.

Table 4: Details of bidding process for selection of Global Advisor Sl.No. Name of PSU Number of EoIs

received Number of parties qualified to make

presentation

Number of financial bids

opened 1 MFIL 9 9 3 2 BALCO 8 7 2 3 HTL 6 5 1 4 CMC 16 13 3 5 IBP 12 12 2 6 VSNL 16 12 2 7 PPL 6 2 2 8 IPCL 9 9 3 9 HZL 14 11 3

Audit noted that in the case of HTL, IMG decided (14 June 1999) to open only one financial bid on the ground that the bidder securing the highest marks was best suited to perform the duties of GA. IMG recommended this bidder considering that the fees quoted by them was at par with the fees of GA appointed for disinvestment of MFIL. It was also recommended that any further negotiation for reducing the fees might result in compromise in quality and engagement of only low paid employees by GA for the work. The Ministry of Disinvestment in their reply (August 2003) stated that there were well defined criteria for selection of GA. Since the difference in marks obtained between the first and second ranked bidders was 7.2 per cent (64.2 minus 57 out of total marks of 100), IMG recommended that the bidder obtaining the highest score only should be invited for negotiation. The Ministrys decision to invite a single bidder for negotiation and not having further negotiation on the plea that any possible reduction in fees would mean sacrificing the quality of work was not a good practice. It would also imply that the Ministry was, in the process, deprived of the best possible choice for a significant exercise including valuation which included rendering assistance in enhancing the value of the stake under disinvestment.

3.3.2 The Ministry of Finance in their reply (May 2006) stated that CGD in its meeting held on 16 July1999, had decided that the process of selection of Global Advisors (GA) should be in two stages wherein, after the initial short listing of the merchant bankers on merit, price offer received from the first two or three parties should be considered before arriving at a conclusion on the final selection.

Report 17 of 2006

______________________________________________________________________________20

The recommendation to shortlist two or three bidders by IMG was in line with the above decision of CGD. Government approved (4 July 2001) a proposal designed to reduce subjectivity and obtain more competitive financial offers, according to which an Inter-Ministerial Selection Committee (an IMG to be constituted by the DOD for this purpose) would set a qualification mark depending on the requirements of the transaction and the number of candidates available. The financial offers of all the firms achieving the qualifying marks would be opened and the bidder with the lowest financial bid among them would be awarded the assignment. 3.3.2.1 Audit noted that Global Advisors for all the nine transactions of disinvestment covered in this report were appointed by 6 March 2001, for which there was no apriori threshold score or benchmark prescribed for shortlisting the bidders, though the Ministry subsequently decided (July 2001) to adopt a more transparent procedure.

3.3.3 Standardization of bid formats No formats were prescribed standardizing the requirements of financial bids for selection of GA and assessing the success fees and drop dead fees. This rendered the comparison of fees quoted by various bidders difficult. Audit noted that in the case of HTL, bidders were asked to resubmit their bids in view of the difficulty in comparison. The Ministry of Finance in their reply (May 2006) stated that IMG in its meeting held on 4 June 1999 and 7 June 1999 decided that the bidder that had secured the highest score on the basis of presentation made was to be considered as the best suited for performing the duties of GA, and decided that such a bidder was to be called for negotiations. IMG in its meeting held on 14 June 1999 asked only one bidder to reconsider its financial bid. While negotiating, the bidder was not informed that they had been considered the best among five bidders. Audit noted that the Ministrys reply was contrary to the view expressed by IMG on 14 June 1999 to the effect that in view of different structuring of the financial bids submitted, it was difficult to quantify and establish the lowest bidder. Standardized bid formats would have helped in achieving better comparison of bids, which was a good practice that could have been followed usefully. 3.3.4 Global Advisors fees The success fees ranged between 0.19 per cent and 1.25 per cent of the gross proceeds in the cases of disinvestment examined in this report. There was no instance of payment of drop dead fee in any of the nine cases. The subject of cost of each disinvestment transaction or cost of sale has been commented upon in paragraph 3.11 of this report.

3.3.5 Advisory Service Agreements with GA were delayed Audit examination revealed that though DOD had issued a mandate or appointment letter to the GAs after their selection, the formal agreement between the Ministry and the GAs was signed after considerable delay, sometimes even

Report 17 of 2006

______________________________________________________________________________21

after approval of sale transaction by Government as indicated in Table 5. In the case of PPL, the agreement was not signed at all.

Table 5: Details of Finalisation of Agreements with GAs Sl. No.

Name of PSU

Date of issue of appointment letter

to GA

Date of signing the agreement with GA

Date of approval of sale transaction

by CCD

Time taken to sign the

agreement with GA

1 MFIL 7 July 1998 20 October 1998 25 January 2000 3 months 2 BALCO 9 July 1999 14 June 2000 27 February 2001 11 months 3 HTL 13 September 1999 27 September 2001 5 October 2001 2 years 4 CMC 6 March 2001 16 October 2001 5 October 2001 7 months 5 IBP 11 December 2000 31 January 2002 2 February 2002 2 years and

1 month 6 VSNL 5 March 2001 1 February 2002* 5 February 2002 11 months 7 PPL 1 March 2001 No agreement

signed 14 February 2002 Not applicable

as no agreement was signed.

8 IPCL 16 April 1999 16 May 2002 18 May 2002 3 years and 1 month

9 HZL 13 November 2000 9 January 2002 27 March 2002 2 years and 2 months

*Final agreement was signed with the Consortium on 20 May 2002.

Audit noted that as per Government orders, no work should be commenced without proper execution of agreement. It was only in exceptional circumstances and in no other case should work of any kind have been allowed to commence without prior execution of contract documents. However, in a majority of the cases of disinvestment though the letter for appointment was issued to GA after their selection, the agreement was drawn when the process of disinvestment was likely to be completed or sometimes even after the completion of the sale process. The GA was thus left contractually unbound for the entire period, which was not a good practice and did not provide assurance of professional handling of an important aspect of the process of disinvestment. The Ministry of Finance in their reply (May 2006) stated that finalization of the agreement with GA was a time-consuming process. In some cases, the provisions of the agreement also required reconsideration keeping in view the sensitivities of the advisors, requirements of the transaction, besides vetting by the Department of Legal Affairs. However, in future, efforts would be made to enter into these agreements with advisors, as soon as practicable. The Ministry may, incidentally note that the practice adopted was violative of Government orders and was also otherwise not a good management practice.

3.3.6 Modification in the extent of disinvestment was not taken advantage of. In the case of MFIL, HTL and IPCL, the extent of disinvestment was increased after the appointment of GA. However, suitable advantage of these changes were not taken by achieving corresponding reduction in the percentage of success fees of GA though the success fees was directly linked to the quantum of the sale proceeds. The Ministry of Finance in their reply (May 2006) stated that in the

Report 17 of 2006

______________________________________________________________________________22

case of MFIL, by the time the decision to increase the level of disinvestment to 74 per cent was taken by Government, GA had already spent five months on the assignment. In the case of HTL, Audit noted that CGD had decided to appoint GA in the meeting held on 4 September 1999, i.e. almost six months before Governments decision to raise the equity to be divested was taken. The Ministry stated that the process of appointment of GA took about four months and by that time the decision to increase the level of disinvestment to 74 per cent was taken by Government, GA had already spent about eight months on the assignment. Similarly, in the case of IPCL, GA was appointed on 16 April 1999 whereas the decision to increase the disinvestment in IPCL from 25 to 26 per cent was taken on 13 November 2001. By this time, GA had already spent over two years on the assignment. It further stated that it would not have been practical to appoint another GA or to call for a fresh financial bid where GA had already spent considerable time on the assignment.

3.3.6.1 Had the agreement with GA been entered into promptly and had it contained a suitable clause to allow Government the flexibility to take appropriate advantage of the increase in the quantity of stake decided during the process of disinvestment it would have been possible to achieve some reduction in the fees paid to GA in such cases. Simultaneously, Government could also have considered allowing corresponding benefit to GA in cases of any reduction in the quantity of stake sold or any other decision that would have adversely impacted the business valuation adopted during the process of disinvestment. This would have, incidentally, strengthened good practices in the process.

3.3.7 Appointment of Intermediaries According to the instructions issued by the Ministry of Finance in August 1999 for the appointment of intermediaries, the concerned PSUs were to appoint them following their own procedure and pay their fees, which was later reimbursed by the Ministry of Disinvestment. On 4 July 2001, Government approved a proposal of the Ministry of Disinvestment whereby the intermediaries were also to be appointed by the Ministry of Disinvestment itself from the list provided by GA by following the same procedure that was adopted for the selection of GA. Audit noted that except for CMC, VSNL, and PPL, in other cases the PSU being divested had appointed the intermediaries. In the case of CMC both the asset valuer and the legal advisor were appointed by the Ministry of Disinvestment before the procedure for appointment was approved by Government.

3.3.8 Appointment of Asset Valuer The asset valuers were appointed from the panel recommended by GA but the criteria for short listing them were not determined or specified. Audit examination also revealed that adequate time was generally not allowed to the asset valuers. Some instances are given below. 3.3.8.1 BALCO: The valuer was given only 19 days to value fixed assets, which in the view of the asset valuer required at least 45 days. As a result, asset valuation had inadequate documentary basis and adequacy of the valuation of

Report 17 of 2006

______________________________________________________________________________23

civil works and plant and machinery was not verifiable in audit. The Ministry of Finance in their reply (May 2006) accepted that the time available to the asset valuer was rather limited and as a result the valuer had obtained replacement cost through verbal enquiry instead of obtaining the price by sending written enquiries to the manufacturer or supplier concerned. 3.3.8.2 CMC: The Ministry had neither prescribed any time-frame for completion of this job nor mentioned the authority to whom the valuation report and the claims were to be submitted and clarified these details only on an enquiry by the valuer. The Ministry of Finance in their reply (May 2006) stated that the valuer was informed vide the letter of appointment that he had to work in close coordination with GA who was aware of the progress of the transaction and ensured that the work of asset valuer was completed as close as possible to the date of valuation by GA.

3.3.8.3 VSNL: Appointment of the asset valuer was done without conducting negotiations making it open-ended and at the highest quote. The Ministry of Finance did not explain any reason in their reply to Audit in May 2006.

3.3.8.4 Audit could not verify / comment on the procedure adopted for the appointment of asset valuer, legal advisor, chartered accountant and environmental consultant in the case of disinvestment of IBP and IPCL as the records relating to their selection and appointment were not made available by the Ministry of Disinvestment.

3.3.8.5 The Ministry of Finance in their reply (May 2006) stated that generally, a time of six weeks was given for asset valuation. The asset valuer was also informed vide the letter of appointment that he had to work in close coordination with GA who was separately advised to keep the details of the matter confidential. This was stated to be essential to ensure that the asset valuers report was ready as close as possible to the date of valuation of the PSU so that the data remained relevant. Hence, a time limit for submission of the report could not have been given in advance.

Recommendation The Ministry may define the scope of work of the Global Advisors and standardize the mandate of and the agreement with them so that the latter do not have an open ended and disparate arrangement for what is an extremely sensitive and important exercise intended to aid the process of disinvestment and obtain the maximum value for the stake under disinvestment. The asset valuers would need to be given adequate time to prevent the exercise from becoming redundant. 3.4 Valuation Valuation is a central issue in any disinvestment, particularly in the case of a strategic sale. The Ministry prescribed four methodologies of valuation in the guidelines for valuation issued in May 2001 to be used by GA, as briefly mentioned in paragraph 1.13.1 above.

Report 17 of 2006

______________________________________________________________________________24

3.4.1 Discounted Cash Flow (DCF) Methodology This methodology expressed the present value of a business from its projected future earning capacity. Future cash flows were worked out on the basis of past performance and projections which, in turn, were to be based upon assumptions in the areas affecting production, sales, taxation, working capital, capital and revenue expenditure and were discounted at an appropriate discount factor (also called the Weighted Average Cost of Capital (WACC)17). The discount factor (WACC) was a function of the debt equity ratio, cost of debt and cost of equity18. Assumption of a higher cost of debt and equity would have increased the magnitude of the discount factor leading to depressed enterprise value19 and vice versa. A flow diagram for calculation of discounted cash value has been indicated at Annex IV. Audit examination of the valuation exercise carried out by GAs in the nine PSUs disinvested revealed the following.

3.4.1.1 Absence of business plans20 Business plan which contains the future projections and strategy of the PSU was an important document that would have enabled a comparison between the projections of the PSU and GA while examining the appropriateness of business valuation. This document was not available for examination in audit in respect of VSNL, HZL and IPCL. The Ministry of Finance in their reply (May 2006) stated that in the case of VSNL, other than the National Long Distance (NLD) business plan, no other business plan was provided to GA by the PSU while HZL was not in a position to provide detailed business plan for the next three to five years and GA made assumptions regarding the future financial performance. Audit noted that GA had disclosed in the valuation report that valuation assumptions were not validated by HZL, which seriously hindered the reliability of the valuation. The Ministry further stated that the business plan of IPCL had been called for and copy thereof would be provided to Audit when received from GA.

17 Weighted Average Cost of Capital (WACC) is the discount rate applied to estimate the present value of explicit forecast period free cash flows as also continuing value. The principal elements of WACC are cost of equity, the post-tax cost of debt and the target capital structure of the company (a function of debt to equity ratio). WACC= (Debt/Total Capital)*(After-Tax Cost of Debt)+(Equity/Total Capital)*(Cost of Equity) 18 Cost of equity is the desired rate of return for an equity investor given the risk profile of the company and associated cash flows. Cost of equity = Risk free rate + (equity risk premium x ), where (beta) of a company reflects the underlying risk of a business over and above the stock market risk. 19 Enterprise Value is the market value of equity plus debt or total market asset value of the company. 20 Business plan is a document prepared by the management of a company showing the future projections about the business of the company, keeping in view the economic scenario, future capital investments and the growth potential of the company.

Report 17 of 2006

______________________________________________________________________________25

The availability of a fundamental document like the business plan of the PSUs under disinvestment and a clear record of the reasons for the variation in the projections contained in the business plan and those adopted by GA would have provided an added assurance of the completeness and adequacy of the process followed for determining the enterprise valuation and ultimately the reserve price 3.4.1.2 Audit examination also revealed some instances of improper or far too conservative assumptions having been adopted by GA while arriving at business valuation under the DCF methodology. There were no recorded reasons in the Ministry justifying the assumption made by GA though these had an impact on the business valuation based upon which the reserve price was to be fixed for the stake under disinvestment. Following were the specific instances. MFIL: Audit noted that despite the fact that franchisee operations of the PSU could register significant growth, backed by superior marketing and managerial skills of the strategic partner, income of Rs. 3.2 crore on this account had been ignored in GAs projections. DOD in their reply (March 2001) stated that income from franchisee operations was taken as 'nil' on the basis of the managements feedback to GA. The reply was not tenable as the output of 24 franchisees with a bread manufacturing capacity of 5,54,000 Standard Loaves (SL) per day could not have been simply ignored in any prudent valuation. Audit could not verify the management feedback as it was not found on record. BALCO: The installed capacity for finished products of BALCO had increased to 131,400 MT with the commissioning of a Cold Rolling Mill in 2000-2001. GA however, did not take into account the increase in the capacity of finished products, kept the production pegged at the earlier level of 91,000 MT to 93,000 MT and completely ignored the capacity addition in the pipeline.

The Ministry of Finance in their reply (May 2006) stated that detailed discussion with management and understanding of market trends convinced GA that the new cold rolling mill had been sanctioned because of the obsolescence of the old rolling mill. This obsolescence had led to poor quality of products in comparison to the trends of market demand. GA assumed full capacity of the new cold rolling mill (over a time) and maintained production of old rolling mill at 50 per cent of rated capacity without scaling it down. Had the company outsourced primary metal and tried to increase capacity utilization of the old rolling mill, the market would not have fully absorbed the poor quality material and margins would have declined. The Ministrys contention was not acceptable as BALCOs old rolling mill was working at more than 100 per cent capacity utilization till at least 2000-01, the product was being sold in the market and this facility could not have been considered to become outdated as soon as the new mill was commissioned.

CMC: GAs projections for revenues were on the lower side and those for expenses were higher than those stated in the PSUs business plan but the reasons for the difference were not disclosed in the valuation report. The difference had the effect of depressing the business valuation of the PSU. On being pointed out in audit, the Ministry of Disinvestment in their reply (November 2003) stated that

Report 17 of 2006

______________________________________________________________________________26

there was no basis for the business plan of the PSU, and the projections were adopted by GA based on their discussions and consequent agreement with the management. This was an instance of inadequate or improper documentation of the basis of an important aspect of valuation exercise, which was not a good practice.

IBP: GA had not assumed the figures of sales and margin as per the business plan of the PSU. While projecting sales, GA had reduced the figure by 16 per cent in 2002 compared to 2001 and reduced the same by another 5 per cent in 2003, though there was no instance of reduction in the sales in the past. This ultimately reduced the sales figures for the forecast period to nearly half of the projection depicted in the business plan for 2010 as evident from Table 6 given below:

Table 6: Variation in projections of Global Advisor and the business plan-IBP (Rs. in crore)

Actual Forecast Item 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Income from sale as per

Business Plan (BP)

4690 5670 6819 8076 8565 9615 11294 12997 14968 17261 19622 22247 25138

% increase/ reduction

21 20 18 6 12 17 15 15 15 14 13 13

Income from sale as per

GA

6810 8388 7031 6653 7294 8000 8775 9630 10568 11598 12731

% increase/ reduction

23 (-)16 (-)5 10 10 10 10 10 10 10

The Ministry of Finance in their reply (May 2006) stated that for the period 2005 to 2010, GA had adopted the sales at a lower figure based on their discussions with the management of the PSU. It was also pointed out that from 2002 onwards, while the Oil Marketing Companies (OMC) component of sale had boosted the sales figures these did not have a commensurate impact on profitability which were therefore reduced to zero in the DCF model as it was assumed that no OMC sales would be possible post privatization. The Ministry of Disinvestment did not ensure that GA kept a detailed record of the explanation for the adoption of lower figures of sales along with the exact nature of the discussion with the management of the PSU that was stated to have taken place.

Audit further noted that GA had also made a provision of Rs. 33 crore towards environmental compliance without explaining the basis of the provision. The Ministry of Finance in their reply (May 2006) stated that expenditure of Rs. 33 crore on environmental compliance was due to non-compliance on various counts by the Retail Petroleum Outlets (RPOs) and Oil Storage Facilities (OSFs) on account of a number of environment related statutes. Not only was the reply of the Ministry general in nature but it also did not indicate the exact nature of non-compliance and the basis of computation of the amount of expenditure.

Report 17 of 2006

______________________________________________________________________________27

PPL: Audit noted discrepancies in the production figures of various products projected by GA and those indicated in the annexure to GAs valuation report. The Ministry of Finance in their reply (May 2006) stated that GA had explained the difference in the figures as an inadvertent typographical error. GA was understood to have further explained that the correct figures from their main report had been considered in the computation of business value. Apparently, the details of the valuation report were not checked in the Ministry.

IPCL: GA had projected the sales growth on the lower side compared to the actual performance and had provided the consolidated figure of expenditure without any details while deriving net cash flow in respect of consumption of raw material, employees remuneration and benefits, manufacturing, administration and selling expenses, interest and depreciation. GA had also deducted an amount of Rs. 4275.75 crore indicating the figure as net debt without providing any details. As a result, Audit could not examine the basis of these projections. GA had adopted the Weighted Average Cost of Capital (WACC) as 13.8 per cent. However, while deriving the Free Cash Flow, GA adopted WACC at 15 per cent. Adoption of a higher WACC rate had the impact of depressing the business valuation of the PSU. No reasons for adopting higher value of WACC were found on record.

Audit further noted that GA did not value the joint ventures of the PSU though IPCL had a 37 per cent stake in Gujarat Chemical Port Terminal Company Limited, which operated the liquid chemical handling port at Dahej that was commissioned in 2000 that enabled IPCL to handle export consignments and access feedstock. The PSU also had an investment of Rs. 25 crore in GE Plastic India Ltd, which remained to be valued.

The Ministry of Finance in their reply (May 2006) stated that comments of GA had been called for and reply was awaited. This only underscored the absence of records in support of the valuation by GA in the Ministry, which was not a good practice.

HZL: Audit examination revealed that though GAs projection period covered 2002 to 2023, the projection for revenues, expenses and costs for the explicit forecast period21 2006 to 2022 was not indicated by GA in the valuation report. Moreover, GAs projection of sale of Lead and other products were unverifiable as the basis of projections of the quantity sold in respect of such products for the explicit forecast period were not explained in the report. Normative tax rate of 35.7 per cent assumed in the first round of bidding in November 2001 was later increased to 36.8 per cent in the second round of bidding in March 2002 without furnishing any reasons, though the tax rate had not changed in 2001-02. Adoption of higher tax rate without any justification had the effect of depressing the enterprise value.

21 Explicit forecast period is a period of time (5 to 10 years) for which the net present value of the free cash flows arising from the business is projected under the DCF method.

Report 17 of 2006

______________________________________________________________________________28

The Ministry of Finance in their reply in May 2006 stated that in respect of projections of sale of Lead and other products, attempts were made to obtain the comments of GA who had ceased operations in 2002. GA did not have any employees now and were not in a position to offer comments on any of the mandates undertaken by them or the basis for various calculations, valuation and analysis done for arriving at financial evaluation while undertaking the HZL mandate.

Audit noted that the Ministry had again not kept any record of the assumptions behind the valuation exercise carried out by GA though these affected the business valuation. 3.4.1.3 Inconsistency in computation of equity value The enterprise value of a PSU is worked out by discounting the value of free cash flow22 arrived at under DCF methodology by applying WACC as the discount rate. The equity value is worked out thereafter by deducting the net value of debt of the PSU from the enterprise value. As per the formula used for calculating the discount rate indicated in the foot note 17, if the cost of debt is not taken into account, the discount rate becomes higher than the case where the cost of debt is taken into account.

Audit examination revealed that the GA concerned had, while valuing MFIL, BALCO, CMC, HTL, and PPL which were not zero debt PSUs, taken into account cost of debt while estimating WACC. The net value of debt as on the valuation date was correctly deducted from the enterprise value so as to arrive at the equity value of the PSU concerned. In the case of IPCL, the basis for the deduction of net value of debt by GA was not ascertainable from the records produced. Audit further noted that in the case of IBP and VSNL, both zero debt companies as on the date of valuation, GA concerned did not take into account the cost of debt while estimating WACC and also did not deduct any value of debt while working out the equity value from the enterprise value.

Audit examination of the valuation of HZL under DCF methodology, however, revealed that though the PSU had debt on the date of valuation, GA had not taken any cost of debt while working out WACC. In addition, GA had deducted the amount of net debt of Rs. 38.2 crore from the enterprise value before deriving the equity value. The practice of deducting debt from the enterprise value without adopting cost of debt in estimating WACC was inappropriate.

The Ministry of Finance in their reply (May 2006) stated that GA had assumed the target debt to equity ratio at zero percent for estimating future cash flow as the level of HZL's debt had been historically very low. However, while deriving the equity value, GA deducted Rs. 38.2 crore from the enterprise or firm value, being the net debt outstanding as on 31 December 2001. The Ministrys reply 22 Free cash flow (FCF) for a year is derived by deducting the total of annual tax outflow inclusive of tax shield enjoyed on account of debt service, incremental amount invested in working capital and capital expenditure from the respective years profit before depreciation interest and tax (PBDIT) for the explicit period.

Report 17 of 2006

______________________________________________________________________________29

was not convincing as the amount of net debt deducted by GA from the enterprise value worked out to almost 9 per cent of the paid up equity capital of the PSU and could not be considered very low. The action of GA resulted in adoption of a higher WACC, which did not take into account the cost of debt and ended up depressing the enterprise value. The equity value was also depressed as GA had deducted the amount of net debt equivalent of Rs. 38.2 crore from the already depressed enterprise value. Audit examination thus revealed deviations and variations between assumptions of different GAs and the projections made by the PSUs in their business plans wherever these were available and there were no documented records in support of the deviations. Consequently, the reasonability and the validity of assumptions could not be fully assured and the Ministry ended up furnishing replies essentially defending the action of GAs while assuring that the omissions would be rectified or avoided in future and that the minutes of consultation between the management and GA would be recorded in future cases of disinvestment. Issue of standard guidelines to GAs and maintenance of detailed record of the assumptions and justification in support of the treatment of crucial items in the projections adopted by GA would have helped in achieving increased levels of transparency that the procedure of disinvestment deserved. 3.4.2 Asset Valuation Methodology The asset valuation methodology estimated the cost of replicating the tangible assets of the business at market value. Alternatively, this methodology could also disclose the amount which could be realized by liquidating the business by selling all tangible assets of a business and paying off the liabilities. GA was required to make an adjustment on account of net current assets, voluntary retirement schemes (VRS) and capital gains tax in the asset value derived by the asset valuer. It was to provide a good indicator of the value which could be realized if the business were to be liquidated or even if the business was to be replicated. It was significant because most of the PSUs slated for disinvestment had large chunks of unutilized or under utilized land and buildings, plant and machinery whose value might not have got captured efficiently in other methods. Some of these assets might not be considered essential for the running of the business, also called non core or surplus assets and hence might not have figured in the valuation of the business by the potential buyers. Nonetheless, these non-core assets ought to have fetched good value to Government. Audit examination of the asset valuation methodology adopted in nine disinvested PSUs revealed the following.

3.4.2.1 IBP: The PSU had appointed six asset valuers for valuation of the assets located at different regions. While three asset valuers furnished the value of the assets as on 31 December 2000, one had furnished the value as on 1 March 2001 and the remaining two valuers had furnished the same as on 31 March 2001. It was also noticed that four valuers had not mentioned the rationale for the selection of the sample depots, retai